Saturday, April 14, 2007

Dennis Berman over at The Wall Street Journal recently penned a piece on one of the perennial bugbears of Wall Street, league tables, in which he managed to sound both amused and plaintive at the same time:

The tables have become home to the most petty and wheedling impulses of the industry's most-respected institutions, which are rabid about staying high in the rankings. If you want to understand the Street at its absurd best, watch men in Rolexes grub for credit for deals they barely worked on for clients who probably won't pay them.

Mr. Berman does a good job outlining the issue, and was even able to persuade a few investment bankers to admit on the record what a joke the whole thing is. (Of course, when the sharpest comments come from big bank apostates like DLJ- and Citigroup-refugee Hal Ritch, it's sort of hard to hear the message over the sound of axes grinding.)

While he does mention securities underwriting league tables in passing, Berman focuses primarily on those rankings which purport to show investment banks' market position in advising on mergers and acquisitions. This is appropriate, since at least the debt and equity underwriting tables published by Thomson, Dealogic, etc. are based on facts. In order to be given credit for underwriting a securities placement, a bank actually has to underwrite part of it, and given the risks and liabilities involved in fobbing off dodgy trash to widows and orphans (not to mention Fidelity Investments), the SEC and the Plaintiff's Bar make damn sure everyone responsible is listed in clear 14 point type on the prospectus front cover. (This is not to say that these tables cannot be and are not manipulated, both before and after they are published, but at least they maintain some tenuous connection to reality.)

M&A league tables, in contrast, are and always have been a farce. There are no uniform reporting requirements concerning advisory roles or fees for M&A transactions. In order to be given credit for advising on a deal, all a bank has to do is persuade a client to confirm to the reporting services that it worked on it. No real work need take place, and no real money need change hands. Hence, you get examples of highly-discounted or no-fee "services" being "performed" by five, six, or eight otherwise totally uninvolved banks solely in order to claim credit for a big or high profile deal. It is not unheard of or even rare for a bank to deliver a last-minute "fairness opinion" for no fee at all in order to get full credit for "advising" on a $30 billion transaction.

But if, as Mr. Berman reports, everyone knows these league tables are crap, why does Wall Street spend so much time and energy gaming them?

Well, for one thing they are good recruiting tools. All those eager university and business school graduates who are aching to rub shoulders with John Mack, Stan O'Neal, and Henry Paulson What's-His-Name are massively impressed by league tables that show which of their preferred future employers has bragging rights in particular business areas. Their starry-eyed naiveté usually vanishes the first time they are ordered by a superior to "massage" a league table to show a prospective client that notwithstanding a #8 ranking in published tables their bank is really #1 in the narrowly defined subset of deals the bank's Managing Director wants the client to care about. (Strangely enough, the footnotes describing the constraints and limitations imposed on the virgin data rarely seem to survive the printing and binding process for the presentation books that make it to the client. It must be something in the software.)

Second, the published league tables, which tend to appear in the general financial press every quarter and often with higher frequency in the i-bank trade rags, are a nifty form of free advertising. Who, I ask you, does not like free advertising?

But third—and perhaps most surprising—at the end of the day investment banks spend enormous energy and real money on league table positioning and presentation because their customers want them to.

"But wait," you say, "I thought every client knows that league tables are crap." They do, but they want them nevertheless.

Before I explain that little paradox, however, let me preface my remarks by adding that not every client values league tables. As you might expect, i-banking clients that are knowledgeable, experienced, and frequent deal-doers treat traditional league tables the way you or I would treat a piece of dog doo-doo on the street: they wrinkle their noses, step around the mess without really looking at it, and move on. Such customers know all the banks involved, they are familiar with the products or services they are asking the banks to deliver, and they often have more direct deal experience than the Kiton-clad idiot purporting to service them. League tables are completely superfluous to such clients.

For a sense of how an educated consumer of investment banking services does select and evaluate its advisors, I invite you to turn to a recent Bloomberg News profile of Pamela Daley, chief M&A honcho (honchette?) at General Electric Corporation. GE spends about half a billion smackeroos per year on securities underwriting and M&A advisory fees (about the same as the biggest private equity shops), so Ms Daley and her minions have enough in-house data and experience to develop and track their own i-bank performance criteria. I can't imagine they have looked at a standard league table in years:

GE evaluates and measures everything, rating its bankers every six months. It asks about 50 questions to gather complaints, praise and comments on recent deals. This year, Daley is adopting a second survey.

The main question in both is: How likely are you to recommend this bank to a colleague? A score from 0 to 6 is labeled a detractor, from 7 to 8 is termed passive and from 9 to 10 is a promoter. GE calculates the percentage of promoters and subtracts from it the percentage of detractors.

"It's a very small handful of banks that have a positive net promoter score,'' she says.

GE shares reviews, good or bad, companywide, potentially blowing chances for bankers in dozens of industries. "If you're great on energy and lousy in health care, doing something mediocre in health care will get over to the guy at energy,'' Daley says.

(Yikes!)

Admittedly, GE is an extreme example, but this article puts me in mind of Miss Elizabeth Bennet's reaction upon hearing Mr. Darcy's criteria for an accomplished woman:

"I am no longer surprised at your knowing only six accomplished women. I rather wonder now at your knowing any."

But most potential investment banking clients have nowhere near the expertise or experience that GE does in this area. M&A, for most companies, is a rare thing, a once in a lifetime event fraught with all sorts of terrors and confusions. Furthermore, it is not trivial to say that every M&A situation is truly different, so even if you are in the minority of corporate managers who have actually been involved in a deal, it is almost certain you will not be completely prepared for the next one. Lastly, very few corporate executives are capable of judging the quality of advice given to them in the course of a deal, since (a) they usually cannot figure out exactly what is going on in the room at any particular time and (b) the outcome of any deal depends on an extremely complex interaction of numerous factors, only one of which is the skill of their advisor.

Mergers and acquisition advice is an archetypal example of what Charles Green over at The Trusted Advisor calls "complex intangible services." M&A advice is hard to deliver, impossible to evaluate ex ante, difficult to evaluate ex post, and embedded in a deal process where the criteria for success are multifaceted and highly variable across deals. It is widely viewed as expensive, although at around 1% of aggregate deal value (and declining as a percentage the larger the deal gets), M&A fees are trivial in relation to the value at stake, whether you consider that value to be the future health of the company, the reputation and personal financial condition of the senior executives involved, the net worth of the company's shareholders, or the lives and livelihoods of its employees, vendors, and other stakeholders. This is one reason why everyone pays what in absolute terms look like obscenely large advisory fees even as they complain loudly about having to do so. As many an investment banker has asked a reluctant client during fee negotiations, "You wouldn't pick your brain surgeon solely on the basis of who offers the lowest price, would you?"

Mr. Green explains that brand reputation among sellers of complex intangible services is an important screening factor, but by itself cannot clinch the sale:

Buyers of complex intangible services are buying specialized expertise. They dread the thought of having to become expert in the thing they are buying—in fact, that is why they are seeking an expert. Given a choice, they prefer to find a qualified expert they trust, rather than evaluate the expertise of many experts.

In complex intangible services, branding can provide the initial "short list." Since these are fragmented markets (consider the market share of the top 5 law firms or consulting firms, compared to the top 2 soft drinks), name recognition is helpful.

Once in the door, however, the trust evaluation dynamic takes over. Differentiation at a brand level may have existed when the short list was put together; but another more powerful form of differentiation begins to take over in an actual sales meeting, and brand impressions are rapidly overtaken.

He recommends that a seller of complex intangible services win over a potential client by "demonstrating" his product; in other words, by beginning to work on the problem or issue at hand so the client can see how they would work together and therefore be able to evaluate the advisor's skills and capabilities.

However, for business, regulatory, and legal reasons, this is not possible in M&A. (How do you demonstrate how you would advise on a deal?) Therefore, i-bankers fall back on a weak proxy: they try to demonstrate their skills and knowledge of the client and its needs by pitching merger, acquisition, and buyout "ideas." Often this takes the form of telling a potential client which company or companies it could or should buy, and what the combined entity would look like from a financial point of view. But any self-respecting company which does not already have a good idea of which companies in its industry it might buy and why should be taken out behind the woodshed and shot, and—assuming a basic level of competence with GAAP and spreadsheet tools—pro forma financial projections are trivial.

Therefore, unlike for many other complex intangible services like accounting, law, and consulting—where a client has a good chance of being able to "test drive" its advisors before it hires them—potential consumers of M&A advice are thrown back on two primary sources of information to use in choosing an advisor: public brand or reputation, and what the investment bankers tell them. Now, most corporate executives are clever enough to perceive when they are being sold, and most investment bankers are pretty effective salesmen and women, so being able to point to some sort of external validation of a bank's skills and reputation is a valuable thing. (Remember how no-one used to get fired for picking IBM? Well no-one gets fired for picking the #1, 2, or 3 M&A advisor, either, even if the deal goes completely pear-shaped.) Hence the continued reliance on published league tables.

The fact that these league tables are widely known to be manipulated does not dissuade the average client, either. You can argue that the fact that a bank is able to persuade big clients to give it public credit for work it has not done is a pretty good indication of decent client relationships and persuasive negotiating skills, both of which are important M&A advisory skills in their own right. And, the mere fact that i-banks so obviously scrap, struggle, and expend copious resources they could otherwise use in their main business trying to reach and stay at the top of the industry league tables month after month is reassuring to clients that the bank in question (a) has surplus resources to devote to an apparently noneconomic activity and (b) cares about its reputation. This is analogous to what naturalists would call a marker of genetic or reproductive health: the same reason peahens look for the gaudiest peacocks with the most energetic courtship dances, even though such activities and energy expenditures on the part of the male are wasteful and even dangerous from a pure survival perspective.

Finally, it is important to remember that investment banking is at its core a network business. Investment banks' skills and capabilities derive from the extensive personal and business relationships of its professional employees, and this is arguably the most compelling value proposition any investment banker brings to a client. What better way to demonstrate the strength of your network, and the extent of your connectivity, than a league table showing how many deals you worked on and how many clients you served? Even if some of them are fake.

That is why league tables won't go away, and probably will not materially change from their present form. Besides, Mr. Berman and his compatriots in the financial press should be ecstatic that Wall Street is as venal, corrupt, and farcical as it is. After all, that makes for better stories, doesn't it?